This article might be interesting for all non-finance professionals who wonder what financial theories and concepts are truly needed on a day-to-day basis.
I will start with the most fundamental from my point of view theory, which is called time value of money (or just TVM). The basis for this theory is an understanding that money received today is not the same money that someone promises you tomorrow, one year from now or even 10 years from today.
Why exactly is that, you might wonder, do we plan to change our currency from dollars to something entirely different?
No, of course not, but to understand this interesting concept you need to ask yourself a simple question: what can you do with money received today that you can’t do with money received, say, one year from now?
You can’t invest them for one year and receive interest on your investments. And here I am not talking about risky investments, like the ones to equity markets, for example. I am mostly concerned with more standard savings accounts or certificates of deposit which might be even insured in some countries up to a certain limit, so even the most risk-averse person should not worry about losing their money.
Artem Malinin, Ph.D, MBA
Risks associated with TVM
Moreover, if you think about risks associated with deferred payments – is there really a guarantee that a person or a company that promised you a payment in the future will not go bankrupt during this one-year period?
That’s why time value of money theory shows that money received today could be exchanged only for more money promised tomorrow considering opportunity costs, potential inflation as well as non-payment option in general.
Inflation, for example, with prices rising much more frequently than one wants them to, will probably make the most sense nowadays, even for people from developed countries which recently are also facing this problem that inherently has been the attribute of only emerging economies.
The simplest formula that shows the connection between present and future value of money is the following: PV=FV/(1+I)^n, where PV stands for present value; FV for future value; I for interest rate and n represents the number of periods as the longer in the future you are promised the payment, the less is its current value in today’s dollars.
How to use TVM theory
How can you use TVM theory I real life you might ask?
For example, you are contemplating buying a car, something that many people dream about. In this case, there might arise a question of whether to buy the car with cash, finance such a purchase or, maybe, lease it for some period.
All those questions might be easily answered if you understand the time value of money theory as it involves comparison of the costs in the present time rather than in the future.
Let’s start with the cash purchase first, which is the easiest option – you just pay for your car right away and you incur all your expenses at the present time.
The second option, which is financing, might be trickier bearing in mind that you need to consider your initial downpayment and future monthly payments as well.
The main difference between financing a car and leasing it is that you end up financing the whole price of the car versus just a depreciation while leasing, meaning the part of the cost that the car will lose after two or three years of your lease contract’s term.
Richard King
The financing option could also be refinanced in the future while lease agreements usually do not have such an opportunity. While comparing those two options, leasing and financing, you need to understand that your monthly payments will happen in the future and as such cost less, according to time value of money theory, in present terms.
For a financing option, you also need to factor in potential resale value of your car after some years, depending also on how often you would like to be driving your new car. If your resale value exceeds the amount that you still owe to your financial institution at the time, you need to factor in this positive difference in value that will happen in the future as well and as such should be discounted back to the present using an appropriate value of interest rate I from the formula above.
In conclusion...
As a closing thought, the same time value of money theory is also used in corporate finance as well. Imagine that instead of the car you need to select the best project that will potentially bring your company the biggest monetary benefits.
The steps to accomplish this task are very similar to the ones outlined above – calculate present values of your future cash inflows that you anticipate from each of the projects, considering their appropriate interest rates.
Then subtract initial investments needed to start each of the projects and you will end up with something called net present value (NPV). You then should select the project with the highest dollar return represented by NPV and if NPV of some project is less than zero, meaning that you need to invest more than potentially receive back from the project, you need to decline such a project right away.
My hope is that this article makes finance more interesting for everyone as it shows that concepts of finance might be used in everyday situations and are indeed fundamental for the life of every person planning to make a large purchase.
[Author: Dr. Artem Malinin, Florida Polytechnic University]
